THE DEVELOPMENT OF RELATIVE DIVIDEND YIELD 29
We have found that RDY is an almost perfect negative sentiment indicator. When the RDY calculation signals that it is time to buy, it is really signaling that investors have so shunned/neglected a stock that they are demanding a huge upfront payment for the uncertain future value of the company.
By pushing the stock price down until the dividend yield rises, investors note their displeasure or discouragement with management or a company’s prospects relative to its competi- tors. In some ways, RDY makes stocks act more like bonds, where investors know that yields are the reciprocal of risk.
One of the problems with stocks that reach the RDY “buy”
range is that, generally, no analyst will recommend them. The farther they go into the buy zone, the more likely this is to be true. That makes investors who use the RDY method look like true contrarians, because they are not simply purchasing stocks that are out of favor with Wall Street, but rather, stocks that Wall Street has deserted altogether. RDY offers a disciplined approach to investing and provides a disciplined approach to finding stocks when nobody else is looking for them.
It is not that we are merely contrarians, but rather, like any true value investors, we are always looking to exploit informa- tion gaps in the marketplace. Often the biggest gaps are in stocks that Wall Street has given up on. When analysts stop fol- lowing a company, and when institutions desert it by selling the company’s stock out of their portfolio, a company can have several good quarters, and sometimes several good years, without anyone noticing. We call this a “loss of constituency.”
A typical scenario would be a growth company like Coke or Johnson & Johnson that goes through a transition and is deserted by growth investors, but has not been discovered by value investors. The pharmaceuticals and consumer products companies each saw a mass exodus by growth managers in the early 1990s and late 1990s respectively. The stocks languished until value managers (a new constituency) got interested and prices began to rise.
Johnson & Johnson (JNJ) was another example of such a company—a former growth stock that lost the growth stock investor constituency due to disappointing performance in 1999 and 2000. As growth stock investors fled the stock, it became cheap enough to attract the attention of some value investors. As shown in the RDY chart in Figure 3.4, the stock had never been this cheap since 1962 when the data first became available.
At the time, JNJ was facing a number of internal and external challenges. The threat of political pressure and/or legislation to curb the industry’s pricing was pressuring the stock prices of many firms in the pharmaceutical sector. Add to that several drugs facing patent expiration and the removal of Propulsid (heartburn medication) from the market due to rising fatalities, and it was easy to see why the stock price plunged so dramatically. Clearly, earnings growth momentum had stalled, and growth stock investors were tripping over each other to unload their holdings.
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3/62 9/63 3/65 9/66 3/68 9/69 3/71 9/72 3/74 9/75 3/77 9/78 3/80 9/81 3/83 9/84 3/86 9/87 3/89 9/90 3/92 9/93 3/95 9/96 3/98 9/99 3/01 9/02
Relative Dividend Yield Buy
Sell
Figure 3.4 Johnson & Johnson (JNJ) Relative Dividend Yield Source:Data from Compustat.
THE DEVELOPMENT OF RELATIVE DIVIDEND YIELD 31
However, RDY focuses the value investor’s attention on valuation. This was a company with a powerful consumer and pharmaceutical franchise. Through acquisitions, JNJ had one of the largest biotechnology franchises in the industry. Based on the historically high RDY the stock was trading at, the mar- ket was clearly not attributing value to many of JNJ’s underly- ing, industry-leading businesses. When one class of investors sheds a holding, there can easily be a valuation mismatch for a moderately long period of time. If the underlying fundamentals are sound (see Chapter 5), this is usually a remarkably good time to begin accumulating the stock.
This was true in the case of JNJ. Value investors using the RDY discipline were able to capture the inefficiency in the stock price as growth investors fled the stock, and buyers were scarce.
It is important to note that, in certain situations, RDY does not work or no longer works. The primary example of when this comes into play is when RDY and Relative Price2are not correlated. A good illustration of this is the electric utilities industry. As shown in Figure 3.5, American Electric Power’s
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3/62 9/63 3/65 9/66 3/68 9/69 3/71 9/72 3/74 9/75 3/77 9/78 3/80 9/81 3/83 9/84 3/86 9/87 3/89 9/90 3/92 9/93 3/95 9/96 3/98 9/99 3/01 9/02
0.00 0.10 0.20 0.30 0.40 0.50 0.60
Relative Price
Relative Dividend Yield
Relative Price Relative Dividend Yield
Figure 3.5 American Electric Power (AEP) Relative Dividend Yield and Relative Price
Source:Data from Compustat.
RDY and Relative Price disconnected (note the continual decline in Relative Price.) RDY charts for other utilities showed the same pattern, indicating that RDY is not an appro- priate way to evaluate stocks in that sector. This situation can also occur on an individual stock basis, which is why the pattern of RDY to Relative Price must be checked whenever one evaluates a new stock with the RDY methodology.
The value of RDY as an investment tool is that it provides a rational, nonemotional basis for making sound investment decisions. RDY does not prevent emotionalism in investing, but it provides high-quality information and real notice of pre- vailing sentiment. When individuals are turning against a stock by selling it, the dividend yield will go up. It is that simple fact which makes RDY a reliable methodology for determining when a stock reaches a price range in which it might be bought, if the fundamentals are also there.
RDY works very well as an investment methodology. The results convinced us that we were on the right track with the new investment discipline. Ultimately, the economy would evolve, and this evolution would limit the universe of stocks for RDY investors, and consequently the ability of RDY alone to deliver returns that were consistent with the very best fund managers.
NOTES
1. Relative Dividend Yield: Common Stock Investing for Income and Appreciation(Wiley 1992) by Anthony Spare and Nancy Tengler pro- vides a more detailed explanation of the development and implemen- tation of RDY.
2. Relative Price is the price of the stock versus the price of the S&P 500.
When first charting a stock, it is important to chart Relative Price over time to ensure that Relative Price is not showing a pattern of contin- ual decline.
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